Setback to the market regulator

A controversial ruling by the Appellate Authority in the Finance Ministry has reversed a SEBI order and absolved Hindustan Lever of charges of insider trading.

V. SRIDHAR

THE Securities and Exchange Board of India (SEBI), the country's regulator of the securities markets, has suffered a blow in its first - and a high-profile - test case of insider trading regulations. On July 14, the Appellate Authority in the Finance Ministry set aside SEBI's March 1998 ruling that Hindustan Lever Ltd (HLL), the biggest Indian company in terms of market capitalisation, had indulged in insider trading on the eve of the merger of Brooke Bond Lipton India Ltd (BBLIL) with it in 1996. Both HLL and BBLIL were subsidiaries of Unilever.

Although HLL has reasons to be euphoric over its latest victory, the case offers important lessons for it in corporate governance.

The Appellate Authority has reversed SEBI's order that the company and five of its directors be prosecuted and also struck down the ruling that HLL pay Rs. 3.04 crores to the publicly-owned Unit Trust of India (UTI), the alleged victim of the instance of insider trading. It also said that SEBI's ruling suffered from "procedural lapses" and that it used powers beyond its jurisdiction. However, the grounds on which the Authority based its ruling and the manner in which it interpreted the SEBI (Insider Trading) Regulations, 1992, and the SEBI Act, 1992, have raised a controversy.

The ruling has come at a time when the Government is considering allowing companies to buy back their shares. There are fears that the precedent set by the Authority may affect SEBI's ability to curb insider trading. Although P. Chidambaram had announced while presenting the 1997-98 Budget as Finance Minister in the United Front Government, that share buy-backs would be made possible during the financial year, the proposal was delayed primarily because it was feared that companies would misuse it. The Authority's order has strengthened the fears that a weak piece of legislation on insider trading will allow companies to manipulate share prices, using privileged information not generally available to the market.

RAJEEV BHATT
D.R. Mehta, Chairman of the Securities and Exchange Board of India.

It is not just the merits of the order that are being contested; more fundamentally, questions are being raised about the structure of the Authority. A specific question is whether officials in the Finance Ministry - in this case, Montek Singh Ahluwalia, Finance Secretary, and C.M. Vasudev, Special Secretary (Banking) - can be entrusted with the task of hearing appeals from corporates with whom they deal with on a regular basis.

In March 1998, SEBI ruled that HLL had indulged in insider trading while purchasing eight lakh BBLIL shares from the UTI on March 25, 1996 (Frontline, April 17).

In April 1998, both HLL and UTI appealed to the Authority against the SEBI order. While HLL pleaded that it be absolved of the charges of insider trading, the UTI contended that the compensation of Rs.3.04 crores was inadequate. The Authority had to deal with two crucial aspects of the case. The first related to HLL's contention that it was not an "insider" and the second was whether the information available with HLL was price-sensitive.

SHANKER CHAKRAVARTY
Union Finance Secretary Montek Singh Ahluwalia.

UTI, the second biggest shareholder in both HLL and BBLIL after Unilever (which now has a 51 per cent stake in HLL), had complained that the information on the proposed merger of BBLIL with HLL was not known to it when it bought the shares. SEBI ruled that the companies were well on the way towards a merger and that the directors of Unilever, HLL and BBLIL were actively involved in the exercise. As a result, SEBI reasoned that while HLL, a party to the transaction, had access to privileged "price-sensitive" information, UTI, the other party, had no knowledge of the proposed merger.

HLL also claimed that the market was generally aware of the merger talks and that UTI would have discounted for this in the price at which the share was traded. However, SEBI said that there was a fundamental difference between the general information that was available to UTI and the specific information available to HLL.

Resorting to the legal proposition that "no person can be an insider to himself," HLL argued that it was not an insider as defined in the Act. It told SEBI that it was a separate entity and that its information on the merger with BBLIL arose out of it being a party to the merger and not because it was an "insider". SEBI overruled this, maintaining that the "competence" to decide about BBLIL's merger with HLL did not vest with HLL alone but also with BBLIL and Unilever. Therefore, it said, the information about the merger did not "constitute HLL's own knowledge about its own affairs or even its knowledge as a principal party." SEBI pointed out that a core team, comprising the directors of BBLIL and HLL, had been formed in January 1995 and that Unilever had granted "in-principle" approval to the merger proposal in January 1996. The core team, it held, met between March 6 and 10 and decided to make the announcement about the merger on April 29. SEBI alleged that the company kept back from UTI concrete information on the merger when the transaction was made on March 25, 1996. SEBI also charged that HLL failed in its "fiduciary duty" to UTI, the second biggest shareholder of the company.

HLL laid great emphasis on the fact that it did not have the details of the swap ratio - the ratio at which BBLIL shares were exchanged for shares of HLL - at the time of the transaction. It argued that the mere information about the proposed merger did not constitute price-sensitive information and that only information on the swap ratio would have materially affected share prices. SEBI dismissed this plea, saying that although the swap ratio may be a price-sensitive factor, it was by no means the only factor. It pointed out that HLL had circulated a note prohibiting company officials from investing in the shares of group companies in situations in which mergers or acquisitions were imminent because they would impact on the share price.

The Appellate Authority agreed with SEBI's ruling that HLL was an "insider". It observed that Unilever was the dominant shareholder in both HLL and BBLIL and that they were "connected" and that the merger was not driven by decision processes entirely internal to HLL. Moreover, the Authority accepted the SEBI's ruling that the information on the merger constituted price-sensitive information available to the company. The Authority also agreed with the SEBI ruling that the share purchase was intended to maintain Unilever's holding in the merged company at 51 per cent. In effect, the Appellate Authority concurred with SEBI that HLL was an "insider" in the transaction; that HLL had privileged price-sensitive information; and that HLL had a motive in pushing through the transaction. However, its ruling has been based on the reasoning that the proposal on the merger was generally known.

In support of its ruling, the Appellate Authority cited press reports that indicated "prior market knowledge of the merger." However, by its own admission, there were only a few reports "prior to the actual purchase (of shares from UTI)." The Authority has come down heavily on UTI, suggesting that it was not market-savvy, that it did not know what was generally known in the market. But consider this: If UTI accepts that it knew about the proposed merger, it would be accused of having participated in a collusive deal using privileged knowledge; if it admits that it differentiated between market gossip and rumour and information, it would be ridiculed for not being market-savvy. In fact, the burden of the Authority's ruling rests on the premise that the information was freely available and that trading in that information would not have offered either party any advantage or special privilege.

Lawyers specialising in corporate law have argued that the weightage given to media reports of mergers and other such information cannot be equated to hard market information or concrete information available especially within companies. They allege that the ruling has raised market and media gossip and speculation to the status of hard and accurate information.

SEBI has also been criticised for relying just on the evidence presented by UTI's Chief General Manager. The Authority says that SEBI should have given "due weightage" to "market reports". While exonerating HLL of the charges of insider trading, the Appellate Authority says: "At the same time, it would have been desirable if at the time of purchase of shares, HLL had informed UTI that the core committee is considering the proposal of amalgamation." (In fact, Unilever had already granted in-principle approval for the merger. Moreover, valuers had already been appointed to work out the swap ratio at the time of the share purchase from UTI.) After absolving HLL, the Authority has suggested that SEBI initiate adjudication procedure against the company under less punitive sections of the Act, which, according to legal observers, will at the most mean a fine of Rs. 5 lakhs. Why the Authority has suggested this course is a matter of speculation.

The case assumes importance because it also raises issues of corporate governance. HLL is one of the biggest companies in India with a turnover of nearly Rs.8,000 crores. Unilever, the parent company, is in the process of restructuring HLL's operations through a series of amalgamations, which commenced in 1993 with the merger of TOMCO with HLL. Since then Lakme and Ponds have also been merged with the company.

Unilever's publicly stated strategy is to maintain a 51 per cent stake in the group companies in India and this has had a strong influence in the case. Its pre-merger holding in BBLIL was below 51 per cent. If its intention was only to keep its holding in BBLIL at 51 per cent, it need have purchased only three lakh shares and not eight lakh shares as it did from UTI. However, if it had bought only three lakh BBLIL shares, its holding in HLL post-merger would have fallen below 51 per cent. In fact, SEBI observed that "there is no ambiguity that the purchase was made based on the knowledge of the impending merger".

If Unilever had adopted another route to hike its stake in the merged company - for example, issuing preference shares - it would have had to obtain various clearances from the Reserve Bank of India and the Government, apart from bringing in foreign exchange to buy the shares. HLL depleted its own reserves to buy the shares for one privileged shareholder, Unilever. That in itself is a cardinal sin in corporate governance - favouring one set of shareholders at the expense of others. Moreover, HLL's action violated the legal proposition that what cannot be done directly cannot be done indirectly.

Both SEBI and the UTI are likely to appeal against the Appellate Authority's ruling in the High Courts in Mumbai and Delhi.

Table of Contents

Home | The Hindu | Business Line | Sportstar